Why The Utilities Matter

Includes: IDU, PUI, SPY, VPU, XLU
by: Duncan Parker

This morning nearly every leading sector sat comfortably in the green except for one, the "Dow Jones Utilities Average (DJU)". As a professional trader I spend much of my time searching for confirmation of market direction. A major red flag waves whenever a previously leading sector lags in comparison to strength in other areas.

DJU briefly flashed into the green this morning for what almost seemed a bad tick before trenching lower as the S&P 500 (NYSEARCA:SPY) bumped against prominent resistance just below $168. As the sector sank, some of the air was let out of the bubble in the broader market indices. This could either be conformation bias (i.e. projecting a desired outcome) or a true "tell" as to what this market is watching.

If you're wondering why a sector most associate with a retirement portfolio is important for the health of the overall market, you're not alone. In the current market environment utilities are a critical tell if not for one reason; their vulnerability to a rise in interest rates. In hindsight, utilities were clearly "in-the-know" well ahead of last week's FOMC meeting where the idea the Fed could "taper" rocked the tape; the sector high was put in all the way back on April 30. Due to the expense in financing the upgrading of infrastructure, utilities often find themselves highly levered against interest rates and their outlying debt. If smart money perceives the risk of investing in the bonds of utility companies to not garner significant "value" over their risk free counterparts (US Treasuries, TNX) the bond market is the first place one should expect selling to occur. As most are aware, equities often follow behavior first witnessed in the bond market. Hence, a DJU selloff closing in on a month old this week demands our attention for its potential implications on the broader market.

A great trader once told me to "assume everything that can be known, is known" in reference to price. That can be a difficult concept at first, but it helped me greatly over time. In essence, what it means is "don't fight the trend." The trend in utilities is to the downside for the foreseeable future. Should conditions worsen in the sector, one shouldn't be surprised if dividend cuts are in "baked in" to equity prices. This possibility should keep yield-hunters at bay for the interim while DJU searches for support.

The market is experiencing an unusual dichotomy at the moment; there's no safety in the typically "safe haven" sectors. Bonds are selling off, Utilities are weak, and Consumer Staples appear to be coming unhinged. When nothing works, cash is a position, too. There's no shame in waiting on the sidelines for optimal conditions to return. Perhaps "Sell in May and Go Away" could prove true this year. After a run like we've had in the U.S. equity markets, a pullback is to be expected and may feel severe to those chasing bull market returns. However, there's no reason to anticipate this is the beginning of something larger; at least not yet.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.